FRA (Forward Rate Agreement)
A Forward Rate Agreement (FRA) is a financial contract between two parties that allows them to agree on an interest rate for a future period. An FRA is a derivative instrument that is commonly used to hedge against interest rate risk, as well as to speculate on future interest rates.
An FRA is essentially an agreement to exchange a fixed interest rate for a floating interest rate for a predetermined period of time. The fixed interest rate is known as the FRA rate, while the floating interest rate is based on a reference rate, such as LIBOR (London Interbank Offered Rate).
The FRA rate is set at the time the agreement is made and is based on the prevailing interest rates in the market at that time. The reference rate is determined at the end of the FRA period, and if the reference rate is higher than the FRA rate, the party that sold the FRA (the FRA seller) pays the difference to the party that bought the FRA (the FRA buyer). If the reference rate is lower than the FRA rate, the FRA buyer pays the difference to the FRA seller.
For example, let’s say a company wants to borrow $1 million for six months in six months’ time, but is concerned that interest rates may rise in the meantime, making the loan payments unaffordable. The company could enter into an FRA agreement with a bank, where the bank agrees to pay the company the difference between the six-month LIBOR rate at the end of the FRA period and the FRA rate of, say, 4%. If the six-month LIBOR rate at the end of the FRA period is 5%, the bank would pay the company 1% of $1 million, or $10,000.
FRAs are commonly used by companies and investors to manage their exposure to interest rate risk, as they allow them to lock in a fixed interest rate for a future period. They are also used by speculators to take positions on future interest rates, as they can be bought and sold in the financial markets.
In summary, an FRA is a financial instrument that allows parties to agree on an interest rate for a future period. It is commonly used to hedge against interest rate risk and to speculate on future interest rates. FRAs can be customized to meet the specific needs of the parties involved and are traded in the financial markets. However, they also carry risks and require a good understanding of interest rate markets and derivative instruments.